10.2 Hedge Funds, Strategies, Fees, and Risks
Key Takeaways
- Hedge funds are pooled vehicles that may use leverage, short selling, derivatives, concentrated positions, and flexible mandates.
- Major strategy families are equity hedge, event driven, relative value, opportunistic (global macro and managed futures), and multi-strategy.
- The classic '2 and 20' fee is a 2% management fee plus a 20% incentive fee, often constrained by a hurdle rate and a high-water mark.
- Gross exposure equals long plus short; net exposure equals long minus short. Low net can hide high gross and high leverage.
- Absolute return does not mean always positive, and market neutral does not mean risk free.
Hedge fund purpose and structure
A hedge fund is a pooled investment vehicle that grants the manager broad discretion to pursue a stated strategy. Most are offered privately to qualified or accredited investors and are not regulated like retail mutual funds. The manager may use short selling, leverage, derivatives, concentrated positions, and less-liquid securities.
The label "hedge fund" does not mean the portfolio is fully hedged. Some funds reduce market exposure; others take directional views on currencies, rates, credit, commodities, or corporate events. The common feature is flexible active management, not a guarantee of lower risk.
Strategy families
The CFA curriculum groups hedge funds into a few families. Memorize the return source and the dominant risk for each, because exam questions test recognition.
| Strategy | Return source | Dominant risk |
|---|---|---|
| Equity long-short | Long undervalued, short overvalued stocks | Equity beta and short-squeeze risk |
| Equity market neutral | Offset long and short equity exposures | Model and execution risk |
| Event driven (merger arb, distressed) | Mergers, restructurings, spin-offs, defaults | Deal failure and liquidity risk |
| Relative value (fixed-income arb, convertible arb) | Pricing gaps between related securities | Leverage and convergence risk |
| Global macro | Views on rates, FX, equities, commodities | Large directional loss |
| Managed futures (CTA) | Trend following across futures markets | Whipsaw and crowding risk |
Equity long-short managers buy securities they expect to outperform and short those they expect to underperform; net exposure can be positive, near zero, or negative. Equity market neutral tries to remove systematic equity beta but can still lose from poor selection, factor shocks, leverage, or a short squeeze.
Event-driven funds invest around corporate actions. Merger arbitrage typically buys the target and may short the acquirer, capturing the deal spread; if the deal breaks, the spread widens and losses follow. Distressed strategies buy debt or equity of troubled issuers and may hinge on legal outcomes. Relative-value strategies harvest small pricing differences, usually with high leverage; a small spread can become a large loss if the relationship widens before it converges. Global macro and managed futures sit in the opportunistic family.
Fees and investor terms
Hedge fund fees usually combine a management fee on assets and an incentive (performance) fee on profits. The shorthand '2 and 20' means a 2% management fee plus a 20% incentive fee, though actual terms vary widely. Fees reduce investor returns materially and make manager selection critical.
Two investor protections appear constantly on the exam. A hurdle rate requires the fund to earn a minimum return before incentive fees apply. A high-water mark prevents the manager from charging incentive fees on gains that merely recover prior losses; without it, an investor could pay a performance fee on a rebound that still leaves the account below its prior peak.
Liquidity terms matter as much as fees. A fund may impose a lock-up before any redemption, an advance notice period, and redemption windows (monthly or quarterly). Gates cap aggregate withdrawals during stress. Side pockets segregate hard-to-value or illiquid assets from the main fund.
Risk controls and due diligence
Hedge fund analysis must separate gross exposure, net exposure, leverage, concentration, liquidity, counterparty exposure, and operational controls. Gross exposure = long + short. Net exposure = long − short. A 130/30 fund (130% long, 30% short) has 100% net but 160% gross. A fund can show low net exposure while carrying high gross exposure and large leverage.
Operational due diligence reviews service providers, custody, valuation policy, trade reconciliation, compliance, cybersecurity, key-person risk, and auditor quality. Many hedge fund failures stem not from a bad macro view but from weak controls, fraud, valuation manipulation, or hidden leverage.
Structured aid: hedge fund exam filter
- Identify the strategy family before judging risk.
- Distinguish long-short from market neutral.
- Check whether low net exposure hides high gross exposure.
- Apply fees to gross performance, not the reverse.
- Link investor liquidity terms to underlying-asset liquidity.
- Treat high-water marks and hurdles as protections, not return guarantees.
Exam traps
Absolute return does not mean always positive. Market neutral does not mean risk free. Leverage magnifies both good and bad trades. A short position can lose more than the original short-sale proceeds because the price can rise without limit. A high-water mark blocks repeated incentive fees on recovered losses, but it does not prevent losses. The most defensible answer usually acknowledges both opportunity and constraint.
Fund of funds and multi-strategy
Two structures appear regularly. A fund of funds (FoF) allocates across many underlying hedge funds, offering diversification across managers, professional manager selection, and sometimes lower investment minimums. The cost is an extra fee layer (the FoF charges its own fee on top of the underlying funds' fees) and reduced transparency, since the investor sees the FoF, not every underlying position.
A multi-strategy fund instead runs several strategies inside one legal entity under one management team, which can shift capital between strategies quickly and charge a single fee layer, but it concentrates operational and key-person risk in one firm.
Finally, distinguish absolute-return objectives from relative-return objectives. A traditional long-only manager is judged against a benchmark such as the S&P 500; a hedge fund typically targets a positive absolute return regardless of market direction. That framing explains why hedge fund marketing emphasizes Sharpe ratios and drawdown control rather than benchmark tracking, and why exam answers should evaluate hedge funds on net-of-fee, risk-adjusted terms rather than raw return alone.
A hedge fund has long equity exposure of 130% of capital and short exposure of 70%. The fund's gross exposure is closest to:
A high-water mark in a hedge fund fee arrangement most likely:
Which statement about hedge funds is most accurate?